Listener Question: How Overvalued Is Too Overvalued?

Sometimes, so-called "overvalued" companies pay off in a huge way -- look no further than Amazon (AMZN 3.43%). Other times, however, "overvalued" companies take a nosedive the second the hype cycle around them crashes.

On today's episode of Market Foolery, host Chris Hill and Motley Fool contributor Matt Argersinger share some advice for weeding out the pricey winners from the bubbles about to pop. Also, Best Buy (BBY -0.25%) reported some fantastic numbers this quarter, but the stock is down on what management didn't say. And some of the biggest Chinese companies likely are just a few months away from a huge catalyst, when the Chinese government finally loosens domestic restrictions on tech giants like Alibaba (BABA 0.59%), Tencent, and more.

A full transcript follows the video.

This video was recorded on May 24, 2018.

Chris Hill: It's Thursday, May 24th. Welcome to Market Foolery! I'm Chris Hill. Joining me in studio, Matt Argersinger, a happy Matt Argersinger, as I am a happy person as well, because we're Boston Celtics fans.

Matt Argersinger: That's right!

Hill: Good night for the Celtics. Kudos to the Washington Capitals, finally getting to the Stanley Cup after 20 years. A lot of happy Caps fans in the office.

Argersinger: Yeah. Nice to see a hometown team actually have some success around here. [laughs] It doesn't happen very often.

Hill: Yes. We have retail, we have big tech in China, we're going to dip into the Fool mailbag. Let's start with Best Buy. Great headline. First quarter profits came in higher than expected. Their same-store sales were huge on a relative basis. They were up more than 7%, and the expectation was that they were going to be less than 3%.

Argersinger: No, it's great.

Hill: Why is the stock down?! [laughs] 

Argersinger: That's the rub. Here's the problem. Q1 comparable-store sales up 7.1%. Yeah, relative to Best Buy, their guidance, and relative to the retail market in general, it's a great number. And their guidance for Q2, pretty good as well, 3-4% comparable-store sales growth. The problem is, they didn't update their annual guidance, which calls for flat to 2% growth in comparable-store sales. So, if you extrapolate things out, what Best Buy is saying is, "Things are looking great in the first half of the year. The second half of the year, negative comps." 

Now, it could just be that management didn't update their guidance. Maybe they're just being cautious. But, if you add the quarters together and they're supposed to be flat to 2%, and you're doing all these great growth numbers in the first two quarters, something doesn't add up.

Hill: It really doesn't. If you think about the back half of year, that's leading into the holidays, that really should be a time when they're doing well.

Argersinger: Yes. I think this could be either management being cautious, under-promising and ready to over-deliver come Q3 and Q4. But, I actually think there could be some reasons management is being a little cautious. I was looking at a conference call, for example, from Cognex, which is a company we talk about sometimes here at The Fool, we recommended it. Machine automation --

Hill: Machine learning.

Argersinger: Right. They have little robots that work in all these factories that help companies produce efficiently and ship things.

Hill: We had their CEO here a couple of years ago for FoolFest. You interviewed him.

Argersinger: Yeah, Rob Willett came by. It's an incredible company. I was going through their last conference call, and they talked about how the consumer electronics business, which is their biggest vertical -- they specifically called out OLED devices, by the way. We're talking smartphones, tablets, TVs. They talked about the fact that that market, which was growing at 40% for them, for their business, last year, they're going to be flat this year in that business. A big surprise. They were at looking for 20% growth.

Hill: Flat?!

Argersinger: So, they went from growing at these huge rates to flat. You pull that through, and I say, you know, if they're seeing that and they're at the manufacturing level, probably at the retail level, where Best Buy is, they're saying, "This might not be a great year for tablets and smartphones and TVs. Last year was great, this year ... " So, second half of the year, holiday season, tough comparisons, probably wise to be cautious.

Hill: Is it possible that this actually works out well for consumers who are looking for a deal?

Argersinger: I think so. As we know, TVs seem to always get cheaper, so especially on the TV front.

Hill: CEO Hubert Joly at Best Buy has done, I think, a pretty remarkable job. When I think back to maybe five or six years ago, this was a company that had a pretty bleak future when you combined the fact that consumer electronics, the economics of it tends to get worse over time, and they're a big box retailer. The physical transformation of the stores, I thought, was a high degree of difficulty, and they appear to have pulled that off. In terms of this conference call, what was Joly talking about, besides the fact that there was no movement on the guidance whatsoever?

Argersinger: Right. One thing, he led off his prepared remarks, one of the first things he said, he highlighted the new partnership with Amazon and the Fire Tablet TV-enabled smart TVs, that they have an exclusive deal now with Amazon. I thought that was an interesting way to lead off a conference call. It makes me think, what we used to deride Best Buy on is actually maybe their strength nowadays. We used to think, consumers are just going there as a showcase store. I go there, I try things out, I test things, I look at things, and guess what? I walk out of the store, get on my phone, and I buy it from Amazon.

Hill: Amazon showroom.

Argersinger: Right. I think this is a great step for them in the sense that they're doing partnerships like this. They mentioned, for example, the Facebook Oculus as well as something they have in store. You come, you try it out, and now you can probably get a good price on it. I feel like, with some of these devices and electronics, people still want to see them and test them out. And, of course, you have the Geek Squad there to help you out. Me, I'm getting older. The population is definitely getting older. Some of these devices are getting harder and harder to figure out. Especially with gaming and things like that, I think there's probably a reason to go to Best Buy. 

But, one thing I thought about when I was reading more about this relationship they have with Amazon, Roku. We've talked about them. They sell a lot of Roku devices at Best Buy and Amazon. And now that Amazon and Best Buy are partnering up on these Fire TV-enabled smart TVs and really pushing that out, I feel like Roku sales at the margin might see a little bit of a dip. This is where Best Buy and Amazon are leading off of. A lot of consumers are probably going to be gravitating to these Fire TVs and less so to Roku-enabled TVs.

Hill: You had mentioned something on Motley Fool Money a couple of weeks back regarding China that I wanted to talk a little bit about. It was basically the potential for a pretty big catalyst for Chinese stocks, particularly when it comes to the big tech Chinese stocks.

Argersinger: Right. I don't think this is getting enough press, because I think it is a big catalyst. Most of our listeners might not know that the average Chinese domestic investor cannot buy shares in Baidu (BIDU 0.62%) or Tencent or Alibaba, which seems strange, right? The reason is, these are foreign-listed companies. They're obviously Chinese companies, they do 90% of their operations in China, but they're foreign-listed. Many of them are listed in the Cayman Islands, for example. That's just for tax and reporting purposes. The Chinese government forbids most investors from buying shares directly in those companies. 

Well, that could be changing. The Chinese government came out recently and said as early as this summer, they might be allowing these big tech foreign companies to issue new ADRs, essentially -- ADRs in China, which is bizarre to think about. In the U.S., we buy ADRs in foreign companies. Well, in China, they're going to be buying ADRs in their domestic companies.

Hill: In their own companies.

Argersinger: [laughs] I've said this before, but it's as if Amazon was listed in China and American investors couldn't invest in Amazon, even though we obviously use it in the States. That's the scenario. So, if this happens -- and I think it will, certainly by the end of the year -- you're going to see a whole new class of securities in China. 

As a Chinese investor, you don't have a lot of options. Chinese investors tend to have a lot of savings. What they've been doing is buying a lot of real estate, just finding places to put their currency, savings accounts, or domestic-listed companies, which tend to be government-controlled and not very exciting, certainly not as exciting as a Baidu, Tencent, Alibaba or JD.com, or various Chinese companies that are foreign-listed. 

So, if this happens, I think you're going to see a lot of pent-up demand flow through the market. And companies that you might be interested in, like Baidu or Tencent, JD, iQiyi is one we talked about recently, there's going to be a lot of demand from Chinese investors, I think, to pour money into these companies. So, depending on how it arbitrages through the market, I think you could see a big boost.

Hill: Is it also a capital raising opportunity for these companies, as well?

Argersinger: Not really. The way I understand it, and the way our ADRs work here in the U.S., is that it's a proxy for owning a real share. It's not a liquidity event or a company issuing any new shares.

Hill: Before we get in the mailbag, one public service announcement. I try to do a better job of mentioning these types of things, and I realize I haven't mentioned this in a while. For those of you listening who have an Amazon Echo or a Google Home, if you have one of those devices, not only can you get all of The Motley Fool's podcasts on that device, you can also get Motley Fool Stock Watch, which is our daily news brief. It's about 90 seconds long, it's free, it's seven days a week. So, check that out. If you're someone who uses that device for news, you can get a daily Stock Watch from The Motley Fool as part of your news briefing, again, if you have the Amazon Echo or the Google Home.

Our email address is [email protected]. From Wade Cherry in Reston, Virginia. Wade writes, "Over the years, I've come to value valuation less. Nonetheless, I've been burned in the past by buying a hyped company in a hyped industry that was overvalued only to have it drop 75%. I've heard The Motley Fool gang talk about great companies only to note that the valuation is extreme and to avoid it. Knowing that valuation is tricky and that many companies deemed overvalued by mainstream media end up doing very well, do you have some basic guidelines to identify stocks to avoid due to extreme valuations, even if the company itself and the industry it is in look fantastic? Thanks for everything you guys do."

Great question, Wade. I appreciate that he mentioned the media. As someone who consumes a lot of financial media, one of the things I notice when it comes to particularly younger companies is, the comparison is almost always a success story. It's like, "Here's this young upstart online whatever, retailer or something. Yeah, they're burning cash, they lost more money this year than last year, but hey, this could be the next Amazon! Look at Amazon!" And it's like, yeah, or it could be the next eToys, or the next pets.com.

Argersinger: That's right.

Hill: In terms of Wade's question, when you look at something and you check the box like, "OK, by basic traditional valuation metrics, this seems overvalued," what guideposts do you use to separate the opportunities from the, "Oh, no, this is overvalued for all the right reasons."

Argersinger: I'll echo and say great question, Wade! This might be THE question. This is something, I don't care if you've been investing for 30 years, it's a question you will still grapple with. I still grapple with it all the time. I think I can best answer it by telling a really quick story about 3D printing. [laughs] Which we've talked about over the years. You go back, Wade, to early 2014, I'll remember this, I went to the Consumer Electronics Show in Vegas with Mac Greer, our producer. It was pretty much what I'd call the peak of the 3D printing cycle. 

The one thing that struck me at the time is, if you looked at the main 3D companies at the time -- 3D Systems, Stratasys, there's a company called X1, there's Protolabs, which we talk about sometimes -- the combined market cap of these companies in early 2014 was $20 billion. Big number. By all metrics, you look at these companies and you can say, "Wow, they're overvalued, burning cash," just like we talked about, high P/Es, nosebleed, not even profitable. If you looked at the market opportunity of the 3D printing market, in the sense of hardware, software, what's the revenue number that these companies could ultimately capture? At the time, in early 2014, the estimate for that number was $5 billion by 2017.

So, think about it. You're looking at this industry and you're looking at the big players, and the combined market cap of these players is $20 billion, yet the market opportunity for them in a few years down the road is going to be $5 billion. So, they're trading at multiples to their market opportunity. The reason I say that is because I think market opportunity -- sometimes it's referred to as addressable market, if you're reading a 10-K -- it's a great way to gauge whether a company is either just overvalued right now, and maybe it has a great future, or if it's just purely basically overvalued and you should avoid it, even sell it, maybe even short it. You can use that as a great proxy. 

For example, Amazon. You can look at Amazon, every year we look at Amazon. You look at it now, you can say, "It's overvalued. They're barely making any profits, P/Es, nosebleed," all that stuff. But, then you look at, Amazon has basically 4% of the total retail sales in the U.S. Imagine if they had 10% or even 15%. Imagine if they can capture 50% of the online sales in India, which they already are. 

So, you can say, "OK, I have a great business here, great industry, great CEO. But, guess what? The future is multiples of what they're doing today." And if you find those opportunities, and if you hold a bunch of stocks, and you say, "Gosh, I'm worried about this company. It's overvalued. I love the company, I love what they're doing," look at their addressable market. If their addressable market is multiples of their current revenue base or the current market value of the company, I think you're better off holding.

Hill: I would say, related to that, for anyone who's been listening to this podcast for a while, for all the times you've heard Jason Moser talk about the war on cash over the last 12 months, the number of times Jason has talked about the war on cash, part of the reason, I think, is because of the addressable market. So much of the world operates in cash, and the opportunity for payment companies, for Square, PayPal, Visa, MasterCard, etc., it's still, for all the times that we take out our cards and swipe them, in terms of the overall planet, it's still a cash world.

Argersinger: Absolutely! So, you can look at a PayPal or a Square and say, "Gosh, those stocks look incredibly overvalued. I love the businesses, and they're growing nicely." But then you compare it to the market that these companies will be playing in years down the road, I mean, it's massive.

Hill: Thanks for being here!

Argersinger: Yeah, thanks for having me!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. It is Memorial Day weekend, so we'll see you on Tuesday.

Argersinger: Go Celtics!